Sunday, November 1, 2009

The Nature of Money (How money works) in the Economy

The role of money and its impact on the economy is often misunderstood. Many ideas about money today are based on a pre-1960s world-view where money was gold-based. They treat money as a secondary variable to underlying economic forces, equating it to the motor oil that lubricates the economic engine. This view is no longer accurate in today's fiat-money capitalist economies where free flowing capital takes on a life of its own and can drive changes in the underlying economy. This is a reality that a dogmatic Monetarist or Keynesian approach to looking at the economy would miss.

In this post, I describe (my view of) the interrelationship between money, capital and the underlying economy, and how it investors can use this to form a macro-framework for their investment theses.

What is Money / How does something become money

Money is any item that can be offered to induce another person to do work for you, or give you something that he has worked for. In other words, money is the means by which we induce each other to economic activity. It does this in two ways: (1) It functions as a medium of exchange, as a means to induce each other to economic activity, and (2) as a store of value - when stored aside, it represents the ability to induce future economic activity when desired.

In other words, anything that has the following properties can become money: (a) it can be owned, (b) it can be exchanged, and (c) is desired by at least some group of people, is a form of money. In other words, money is more than just the paper currency which we are familiar with. Government issued currency is universal money because it is accepted by everyone, because everyone is willing to work (i.e. carry out economic activity) to get it. Other money, such as rewards points and physical assets like houses, are only accepted by smaller groups because not everyone is willing to be induced to work for it.

The types of items that can be used as money largely depends on society's legal and financial framework. A framework that allows assets such as houses, to have its ownership rights passed between individuals, to be subdivided, and to have agreements on the asset enforced, allow those items to take on the role of money among people who value the item. In countries without reliable property rights and contract enforcement, money tends to be restricted to physical things that can be carried around.

It is important to realize that money is not just the currency. In today's economy, there are broadly 2 types of money:
  1. Central bank issued currency - what we colloquially refer to as money or currency.

  2. Tangible items that are manufactured or extracted from nature - gold, silver, diamonds, seashells, land, houses, cars, antique art, companies etc.

In any economy, people will choose between different types of money to use to store wealth and for buying and selling. The choice of which type of money to convert a person's wealth to depends on a myriad of factors: the expectation that a money type will increase or decrease in its ability to induce others to work, the acceptability of the money to people whose work is required by the holder of the money, and the durability of that money.

The value of a unit of money is the amount of work that it can induce others to perform to get it. In other words, the value of a unit of money depends on the value your intended counterpart places on the money, which depends on what utility he can get out of the money. This utility typically falls into two categories: (1) the amount of work he can induce others to do in exchange for it, and (2) the natural utility produced by the item serving as money. Currency money's value is entirely dependent on the former, except in the case of collectors who may value paper currency strictly for its physical design. For most types of assets (tangible item money), both come into play. Though the utility of the item usually imposes a "floor" on the value of the money. For example, a house has as a minimum utility, the shelter and living condition it provides.

Money is created and destroyed in two ways:
  1. It is manufactured. Tangible item money, such as gold or houses, is created when the items are extracted from the ground or manufactured. Fiat currency money can be created simply by the Federal Reserve creating money out of thin air and depositing into the accounts that banks maintain with the Federal Reserve (In practice, it usually does this in exchange for some non-monetary collateral, such as securities, that the bank pledges to the federal reserve). Alternatively the Federal Reserve can simply buy up Treasury issued bonds. Similarly, the Federal Reserve can create money by giving foreigners dollars in exchange for foreign currency.

  2. IOUs of the money that arise from borrowing/lending are treated like the underlying money. Money is created when the borrower issues IOUs which can function the same way as the underlying money, meaning it can (a) be exchanged for goods and services (i.e. to directly induce others to work) and/or (b) if it can be used as a store of value. This relies on people trusting that they can call in the IOU anytime. For example, if the IOUs can be exchanged for goods and services, then it is effectively a form of money. The total amount of money that is circulating in the economy then becomes the money that was borrowed (and presumably spent, inducing others to work for it), and the IOUs which are being passed around in exchange for economic activity. If a borrower's IOUs cannot be traded for goods and services, then money is not created because the IOU is unable to induce economic activity. The amount of currency that can induce economic activity will not have changed. The money that used to be in the hands of the lender has been transfered to the hands of the borrower.

    For example, if I borrow 20 apples from you and give you an IOU, and you can trade this IOU to another person for some services, then there are 40"apples" running around in the economy that can induce work. (The 20 physical apples I borrowed, and the IOU for 20 apples which you are using). This is the primary mechanism by which fiat money is created, and is also known as the money multiplier effect. The fiat money case is special because fractional reserve banking allows the IOUs (e.g. loan agreements by borrowers) to be treated exactly like cash, allowing the deposits to appear to still be there. (In effect, the IOUs are the deposits in the bank, and accounting rules allow them to be treated as cash, not IOUs). Changes in bank reserve requirements also create or destroy money by affecting the amount of lending/borrowing that can be done.

It is important to understand the nature of money
because it affects the underlying economy

It is important to understand the characteristics of money, because changes in people's preference for storing wealth, or in using one money over another can affect the underlying economy. Interest rates, asset yields, capital appreciation expectations are not just a reflection of the state of the economy; they can actually drive changes in the underlying economy.

(1) Central Bank Currency Money

By virtue of its universal acceptance, central bank issued currency is backed not by the productiveness of one asset (e.g. a house can induce people to work for it only insofar as the living condition it provides) but rather its value is backed by the productive capacity of the entire population / economy.

Because it is universally accepted, it has the special role of being the form of money that we use to measure the value of economic activity. For example, it is difficult to measure the value of a house in Vermont in terms of bottles of apple cider, simply because the people who love apple cider may not be interested in that Vermont house. But it is easier to say a house in Vermont is worth 1 million dollars, which is perhaps equivalent to the services of a doctor to perform 10 surgical operations, or 5 years of legal services, because everyone is willing to be induced by central bank currency because it is ultimately acceptable to the government for tax payments. Without universal currency, we would be back tot he world of barter trade, where the value of a good has to be expressed in the form of another good.

Because central bank currency is universal currency, and because we measure value with it, it alone serves as the measure by which economic decisions are made. Hence things that affect currency money can affect the underlying function of the economy. It affects how we decide to allocate society's resources, and affects decisions on if and how to create productive capacity in the economy.

The value of currency money is preserved if new dollars are created only when new productive capacity is created in the economy, and destroyed when productive capacity is reduced. Changes in the ambient velocity of money, arising from habits and economic structure, need to be factored into the overall money supply estimation. This means that the value of currency money depends on how its creation is handled:

  1. Currency Money created through borrowing/lending. The value of money depends on the ability of economic actors to use borrowed money to create productive capacity. When money is lent to finance the creation of productive capacity, if the productive capacity is successfully created, then the loan can be repaid using the income from the productive capacity. This is also why the banking system should only lend money on the basis of income of the borrowers, or the income that the asset being financed can generate. The banking system should never lend money on the basis of the market value of the asset being financed. The guardians of this are (1) the lending decisions of the banking system and (2) any borrower who can issue tradeable IOUs which can be used as a store of value and medium of exchange. Money has the primary functions of being a store of value, and a derived function as a medium of exchange. Money is created through: debt borrowing / credit extension, provided the borrower's debt is tradeable and hence can be both a store of value and a medium of exchange. The corollary is that the monetary base at all times is seen both as savings and as debt, which means that debt will grow in line with the economy. What is important is that it does not grow as a % of the economy.

    Money is destroyed when borrowers cannot repay their loans, because the loans are written off and shareholder's equity is lost (effectively shareholder's funds are transferred to depositors to keep them whole). The money in shareholder's equity is destroyed to compensate for the money that was given to the borrower, which the borrower was not able to use to create productive capacity. (Had productive capacity been created, income would have been generated to repay the loan). However, at the banking system level, this has the effect of reducing the banking system's ability to lend, because of reserve requirements. Hence to a certain extent, bad lending decisions affect the economy as a whole. Premium based federal deposit insurance (such as the one run by the FDIC) makes this mechanism work by transferring equity from sound banks to those that have made bad lending decisions. However, deposit insurance in the form of government guarantees and actions to prop up a banking system that made bad lending decisions by printing money and putting money onto the banking system's balance sheets (i.e. "investing in them") will debase the currency, because it prevents the money destruction needed to reflect the fact that the earlier lending (money supply increase) did not increase productive capacity.

    Sidebar: Non-fractional reserve deposit taking institutions generally do not create money. They may offer loans (funded by shareholder equity) which allow an asset owner to monetize an asset for a short while. This does no result in the direct creation of money in a big way. Take a pawnshop as an example. The pawnshop is essentially providing a "sell first with option to buy back later" arrangement for the borrower. The borrower "sells the item" to the pawnshop, with the option to buy it back within a certain time frame, failing which the pawnshop can sell the item to cover a non-redemption. The entire flow of money is simply a set of transfer payments (transfer of ownership of currency money) in the economy. This doesn't mean such loans are not helpful to the economy. They can increase the ability of economic actors to increase production, by allowing asset owners to more easily borrow money to invest in new business ventures (i.e. another channel for savers to get their money into the hands of people who can create productive capacity).

  2. Currency Money created by Central Bank domestically. The value of the money depends on the ability of the Federal Reserve to exercise good judgment, and only create new money when economic productive capacity has increased (and vice versa). This is why qualitative judgement, the interpretation of economic statistics to discern the true productive capacity of the economy, and political independence are necessary for central banks.

    The biggest threat to preserving currency value in modern political economy is the issuance of debt by the government which is funded by the central bank printing money (i.e. the central bank buys the government's debt). If this borrowing is used to fund productive capacity in the economy, then the value of the currency will be preserved. However if the borrowing is used to fund consumption, wars, or other activities that do not increase productive capacity, then the money will be debased. If the central bank sterilizes the borrowed amount by destroying an equivalent amount of money, then the value of the currency can be preserved. Likewise, there is no problem if the government repays the loan from the central bank through taxation, because the process will transfer money out of the economy and back into the central bank to offset the initial issue. In other words, money is taken off the market and destroyed. The problem is when the government does not repay, and the central bank does not sterilize (possibly because it wants to avoid reducing the money supply available to the economy).

  3. Currency Money created by Central Bank through foreign currency operations. The value of money also depends on the judgment of the Central Bank to manage the money supply when it accepts foreign currencies from foreign companies and creates new dollars to give to them. Foreign companies then use it to buy goods and services from the domestic economy. (i.e. a net basis, more foreigners want to buy the country's products, leading to a trade surplus). When there is a trade surplus, new domestic currency has been created out of thin air, and foreign currency reserves have increased. Hence trade surplus countries by definition, have a glut of currency money in their economy which the financial system needs to channel into productive capacity creation. For the trade surplus country's currency to hold its value, either the private sector needs to be using it to induce the creation of productive capacity, or the central bank needs to sterilize the additional money (for example through reserve ratio adjustments, or by issuing bonds and borrowing money from citizens in exchange for non-tradeable IOUs).

    In contrast, the country with the trade deficit now has fewer dollars in its domestic economy. There is no actual change in the quantity of domestic currency (provided it was private companies that sold domestic currency to the foreign central bank). The only that has changed is the ownership of some domestic currency has changed from being locally owner to being owned by foreigners.
    By virtue of the fact that the trade between the two countries took place, it means that the trade surplus country's central bank (or private sector) was willing to take foreign currency in exchange for products produced domestically. In other words, the trade surplus country has demand for the trade deficit's country's currency money as a means of storing value. When there is a net trade deficit/surplus between two countries, what has happened is that on a net basis, the one whose products are in demand is trading with the one whose currency is in demand as a store of wealth.

    A corollary of this is that there is no self-correcting mechanism for trade surpluses/trade deficits in a fiat money economic systems. Trade deficits and surpluses were self correcting in a gold-standard monetary system, but are not self correcting with production backed country-level fiat-money systems. The demand for a nation's currency money can allow trade deficits to run continuously, until the demand for the currency tapers off. Hence, there is also no "natural equilibrium" exchange rate for currencies. The only trading bands that currency exchange rates will stay within are the the rates which cause Purchasing Power Parity disparities to become untenable. For example, the exchange rate at which foreigners can buy your products so much cheaper than elsewhere, is likely a rate below which the currency will not fall. Because if it did (and assuming you had the capacity to produce the products, and the product value add is largely domestic), the flood of exports from the domestic economy would create a much larger demand for your products than your currency, and reverse the direction of currency movement (and net trade flows).

(2) Tangible Items used as Money

What underlies the value of tangible item money
There are two components to the value of a tangible item that has monetary characteristics:
  1. Utility Value. If the tangible item produces some tangible value, then the value of the item can be thought of as a multiple of the tangible value. For example, a house provides living space and its location and condition contributes to a certain lifestyle. This "living value" places a lower bound on the amount of work that a person is willing to do in exchange for the house.

    The value of course also depends on the supply of the tangible item relative to the people's demand for it. For example, if there are more good houses than there are people in the population, then it is conceivable that many houses will be worth near nothing.

  2. What other people (whose work you want to induce) think of it value. The fundamental value of tangible item money lies in the minds of people. It depends on how much work a person is willing to do in exchange for getting the item. In other words, the value of the money lies simply in what other people think it's worth. If the item produces no tangible value, then it's value solely lies in what people think other people will give up for it. Sometimes what people think other people think the item is worth (how much work they will do for it) depends on the perceived scarcity of the item.

Most items have value from both counts. For example, antique art is largely "what other people will pay for it"value, but it also has enjoyment value. In most cases, the are outbound markers that mark the outer limits of how people will think of its worth, are based on the utility value, relative the supply and demand situation.

How Monetary Preferences (Asset inflation / Asset deflation) affect the economy

In a modern economy with specialization of labor, people make economic activity and resource allocation decisions with the objective of creating economic value, which is represented as money, so that they can use this wealth to induce a host of other people to perform economic activity that in combination will improve their lives. When people's perception of the value of a money changes, or when people's expectation of its future value changes, it affects their economic decisions. This is how monetary phenomena affects the economy's structure and the amount of economic activity on the existing economic structure.
  1. People switch from preferring to hold currency money to preferring to hold asset money (Asset price inflation) - causing resource misallocation, and long term devaluation of currency money. Capital and asset markets make its easy for people to trade one type of money for the other. People generally choose the type of money to hold based on their expectations of the value of that money over time. This comes from both inflation/deflation expectations, and also market psychology. A market where asset prices are constantly rising can induce market mob psychology, and build in asset price growth expectations. An economy where faith in currency money or government has deteriorated can build expectations that currency money will not be able to hold its value over time. Often these decisions are expressed in daily parlance as the need to invest for capital preservation, of to invest for capital growth and returns, or simply a place to squirrel away one's retirement savings.

    When more people start preferring to hold asset money, the price of asset money in terms of currency money rises. People holding currency money are more and more willing to give up more of their currency money for smaller and smaller amounts of asset money. People trade money with one another, exchanging ownership of money. In the short run, the total amount of currency money and asset money in the economy stays constant. But there are more and larger transfers of ownership of currency money between parties reflecting the increasing prices of asset money being traded for. In the medium term, our propensity to make economic decisions based on currency money indications of value means that economic decisions will be made to create more the assets being used as money (for example houses or gold). This can create a misallocation of resources if the economy fundamentally does not need so much of those items. For example, the rising housing prices may suggest strong demand for houses, which could cause overbuilding because the underlying population may not be big enough to need all the newly built houses. (If you think houses are always useful, have a look at cities like Buffalo, Detroit or parts of Germany where the population is thinning out). This misallocation of resources fundamentally means the loans taken out to build the houses (money created) did not go to creating productive capacity (living space) that was actually needed by the people in the economy. This means the currency money has the potential to be devalued, if money is created to "write-off" the bad loans. It also presents the likelihood that economic activity will be constrained as the banking sector reduces its lending owing to capital destruction caused by loan writeoffs.

    Rising asset prices can also affect individuals' perceived financial savings. They perceive they have more wealth, and so save less income each month. The result is that economic savings (actual saving of monthly income) declines, which reduces the economy's capital formation and future productive capacity.
    A key force that tends to prick asset price bubbles is that as prices and trading volume go up, there comes a point where the transfers of ownership of currency money between asset buyers and sellers becomes so large that there are simply not enough people who own enough currency money left to trade at the prices being asked for. In other words, as asset prices go up, the herd of people who can buy and sell starts to thin out. Market crashes occur when everyone tries to sell at once - there simply isn't enough underlying money to transfer between parties to match the volume of all the shares, even if there are willing buyers in theory. For example, if market capitalization is 15 trillion, and money supply in cash accounts is only 5 trillion, then if all stock holders want to sell at one shot, there simply isn't enough money to transfer to them to buy it. So a price crash occurs. Corollary: The corollary is that as asset prices increase and trading volume increases, the velocity of money increases while the quantity stays constant, until there simply isn't enough money anymore. The duration of this phase can be extended if buyers start taking out loans (debt=credit) to buy the assets, then overall money supply increases. But this only lasts until the maximum debt-to-income ratio is reached, then the bubble will also pop. Unless it kicks into 3rd gear, when people start lending on the basis of asset prices instead of income. This can last a long time. But fundamentally is inflationary because the dollars are now not backed by productive capacity.

    This is one reason why it is useful to watch trading volume in market, once the market capitalization starts getting close to or exceeds the M1/M2 money supply, to see if an asset price bubble is running out of steam. Naturally bubbles can be given a boost if banks start lending to buyers on the basis of expected prices of assets instead of the income of borrowers. This boosts the asset price bubble, and also makes its aftermath worse, as the amount of misallocation of resources becomes much higher and a much larger amount of money destruction is needed to preserve the value of the currency money.

  2. People switch from preferring to hold asset currency money to preferring to hold currency money (Asset price deflation) - causing asset price deflation and reduction in gross capital formation in the economy. Conversely, when people have expectations that asset prices (measured in currency money) are falling, they may start preferring to hold currency money instead of asset money. As more people are willing to give up their ownership of asset money in exchange for currency money that the other way around, the prices of assets will drop. The ownership of both currency and asset money changes hands, with transfers of currency money ownership becoming smaller and smaller in quantity.There is no natural stop to this downward cycle, as eventually the ownership transfers of currency money drops to a negligible level. In the short run, no currency money or assets are destroyed, unless the asset price bubble also involved banks lending on the basis of rising asset prices, and the inability of borrowers to repay loans leads to a destruction of currency money.
    However, in the long run, continuing expectations that asset prices will continue dropping will lead to a reduction in investments in creating assets. People can continue to save their income whilst the economy as a whole reduces its borrowing. In economic terms, economic savings still equals economic investment. However, the economic investment can take place out of the country owing to financial flows. It manifests as monetary savings that continue to increase, but not translate into monetary borrowing. Instead, monetary savings is held in currency money of foreign countries. (This is a probably what is happening in Japan today)

    This can reduce the economy's productive capacity, insofar as these assets are capital goods. People may also stop borrowing money to create capital assets, thus preventing money supply growth, which could induce consumption good price deflation. The only natural force that can stop this cycle is if the population is fundamentally growing and the legal and financial framework allows these people to demand and work for more consumption goods. This can manifest itself in rising consumption goods prices, which in turn, will make the return on assets higher and induce economic investment in capital assets, breaking the asset deflation. (Japan's difficulty is that its population is in decline)

This misallocation of resources caused by changing monetary preferences is probably a part of the economic tempo, caused by the way people relate to money (as a store of value and medium of exchange) and the nature of the way human psychology responds to markets. The way the human mind works in a market environment has not changed over the last 5,000 years. This makes it probable that this economic misallocation behavior occurs like a harmonic wave, with peaks and troughs that occur in each generation whose lives are shaped by large shared experiences.

The takeaway for investors

The takeaway for investors is that economic statistics can mean very little when making macro level analysis of foreign country investments. Trade deficits or negative net international investment positions can persist for extended periods of time. Asset price levels in each country can also change beyond what appears to be levels that can be supported by national income.

The underlying zeitgeist and expectations of people play a large role in sustaining asset price directions, which can in turn affect the underlying economy in ways that support the nominal price increases. To a certain extent, profiting from "secular" changes general asset price levels depends on the ability to identify turning points in the zeitgeist and the expectations harmonic wave.

The key idea is that Money is alive. Changing expectations of its value and changing preferences for different types of money, will drive economic activity in different directions. This is especially relevant in today's world of free capital markets, and improving legal frameworks that allow more and more assets to become capitalized and take on the role of money. In scientific parlance, money is no longer just the dependent variable in the economy. It is often the independent variable in the economic system.

How General Inflation and Deflation affect the economy

General inflation and deflation are monetary phenomena caused by changes in money supply relative to underlying production. They affect both consumption good prices and asset prices, and tend to have different effects in the economy.
  1. General inflation. Inflation happens when there is a general increase in prices of all goods and services across the board. (This is different from spikes in prices for certain goods caused by supply and demand imbalances). Orthodox economic thought says that this happens when

    (a) the quantity of money increases - caused by animal spirits driving people to borrow to the full extent, thus increasing money supply through the money multiplier effect and through central bank printing money into the banking system, and/or

    (b) the velocity of money increases - this happens when animal spirits drives people to trade more frequently, increasing the number of times a dollar changes hands. This could also be because people expect inflation to accelerate, and so opt to use their currency money as a medium of exchange to buy assets instead of as a store of value.

  2. General Deflation. Deflation happens when the reverse occurs.
Inflation and deflation, especially when they are unpredictable, cause damage to the economic system because it makes it difficult for people to make economic decisions. Inflation makes it difficult to invest in creating productive capacity, since the cost of production and the prices which produce can fetch over the life of the production (factory etc) become hard to predict. Inflation also makes it better to be a borrower than a lender, since debts are denominated in nominal sums, and inflation makes it cheaper to pay back future dollars. This can accelerate the borrowing in the economy, which further increases money supply. This can lead to spiraling inflation. It should be pointed out though, that countries like Brazil have managed to grow their economies even with sustained levels of inflation. The key though is that inflation rates while high, they were felt to be predictable.

The takeaway for investors in cases of inflation is that a company's financials need to be examined relative to the general inflation level. Through the early 2000's for example, many Brazilian companies showed 10-20% annual growth in revenue. This was considerably less impressive than it appeared, because much of the gain was purely inflation driven.

Deflation on the other hand, damages the economy by inducing consumption hold-backs, which reduces economic activity. It also increases the burden of borrowers over time, and can lead to social instability because of the stresses it creates in society. For investors, the impact is that deflation can reduce overall economic activity, and affect the general business climate.